Madoff Net Equity Appellate Brief

10-2378-bk(L)

IN THE

United States Court of AppealsFOR THE SECOND CIRCUIT

IN RE: BERNARD L. MADOFF INVESTMENT SECURITIES LLC

ON APPEAL FROM THE UNITED STATES BANKRUPTCY COURTFOR THE SOUTHERN DISTRICT OF NEW YORK

BRIEF FOR TRUSTEE-APPELLEE IRVING H. PICARD, AS TRUSTEEFOR THE SUBSTANTIVELY CONSOLIDATED SIPA LIQUIDATION

OF BERNARD L. MADOFF INVESTMENT SECURITIES LLCAND BERNARD L. MADOFF

10-2676, 10-2677, 10-2679, 10-2684, 10-2685, 10-2687,10-2691, 10-2693, 10-2694, 10-2718, 10-2737, 10-3188,10-3579, 10-3675

d

DAVID J. SHEEHAN, ESQ.THOMAS D. WARREN, ESQ.WENDY J. GIBSON, ESQ.SEANNA R. BROWN, ESQ.BAKER & HOSTETLER LLP45 Rockefeller PlazaNew York, New York 10111(212) 589-4200

Attorneys for Trustee-AppelleeIrving H. Picard, as Trustee for the Substantively ConsolidatedSIPA Liquidation of Bernard L.Madoff Investment Securities LLCand Bernard L. Madoff

Case: 10-2378 Document: 283 Page: 1 09/20/2010 109548 70

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TABLE OF CONTENTS

PAGE PRELIMINARY STATEMENT ...............................................................................1

JURISDICTIONAL STATEMENT ..........................................................................2

STATEMENT OF THE ISSUES...............................................................................2

STATEMENT OF THE CASE..................................................................................4

STATEMENT OF FACTS ........................................................................................7

A. The Relevant Facts Are Not In Dispute......................................7

B. The Structure Of BLMIS And Its Collapse. .............................10

C. The Fraudulent Scheme. ...........................................................13

D. Investments In The BLMIS Fund. ............................................15

E. Generation Of Customer Statements. .......................................16

F. BLMIS Customers’ Investments Were Never Exposed To The Risks Of Market Trading, And The “Profits” Were Fictional...........................................................................17

G. SIPA, SIPC, And Net Equity. ...................................................18

SUMMARY OF THE ARGUMENT ......................................................................21

ARGUMENT ...........................................................................................................22

I. STANDARD OF REVIEW. ...............................................................22

II. UNDER THE PLAIN LANGUAGE OF SIPA, NET EQUITY SHOULD BE BASED UPON CUSTOMERS’ NET INVESTMENTS, NOT THE FICTITIOUS AMOUNTS SHOWN ON THEIR LAST STATEMENTS. ...................................22

A. The Last Statements Did Not Reflect Securities Positions That Could Have Been Liquidated As Of The Filing Date. ..........................................................................................22

B. The “Books and Records” Provision Of SIPA Supports The Net-Investment Method Of Calculating Net Equity..........27

III. THE APPELLANTS HAVE NO LEGITIMATE EXPECTATIONS IN THE PROFITS OF A PONZI SCHEME........30

A. Net Equity Is Not Based Upon Customer Expectations. ..........30


ii

B. Customers Have No Legitimate Expectations In The Proceeds Of A Fraud.................................................................34

IV. BASING NET EQUITY ON FRAUDULENT CUSTOMER STATEMENTS WOULD CONFLICT WITH THE TRUSTEE’S AVOIDANCE POWERS..............................................37

A. Payments Of Fictitious “Profits” In Furtherance Of A Ponzi Scheme Are Made With The Intent To Defraud And Are Not For Reasonably Equivalent Value. .....................38

B. Section 546(e) Of The Bankruptcy Code Does Not Prevent The Trustee From Avoiding Ponzi-Scheme Transfers....................................................................................40

V. THE COURT SHOULD DEFER TO THE INTERPRETATION OF “NET EQUITY” ADVANCED BY SIPC AND THE SEC..........................................................................44

VI. JUDICIAL ESTOPPEL HAS NO APPLICATION HERE................49

VII. THE NET INVESTMENT METHOD MIRRORS THE STANDARD JUDICIAL TREATMENT OF PONZI SCHEMES...........................................................................................51

VIII. BASING NET EQUITY UPON FICTITIOUS CUSTOMER STATEMENTS WOULD BE INEQUITABLE. ................................53

CONCLUSION........................................................................................................56


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TABLE OF AUTHORITIES

PAGE Cases

In re A.R. Baron & Co.,

226 B.R. 790 (Bankr. S.D.N.Y. 1998)..........................................................19, 20 In re Adler, Coleman Clearing Corp.,

195 B.R. 266 (Bankr. S.D.N.Y. 1996).........................................................passim In re Adler, Coleman Clearing Corp.,

216 B.R. 719 (Bankr. S.D.N.Y. 1998)................................................................20 In re Adler, Coleman Clearing Corp.,

263 B.R. 406 (S.D.N.Y. 2001) ...........................................................................41 Auburn Hous. Auth. v. Martinez,

277 F.3d 138 (2d Cir. 2002) .........................................................................29, 43 Bayou Superfund, LLC v. WAM Long/Short Fund II, L.P.,

(In re Bayou Group, LLC), 362 B.R. 624 (Bankr. S.D.N.Y. 2007)....................................................38, 39, 43

In re Bernard L. Madoff Inv. Sec. LLC, 424 B.R. 122 (Bankr. S.D.N.Y. 2010).........................................................passim

In re Bevill, Bresler & Schulman, Inc., 59 B.R. 353 (D.N.J. 1986) ..................................................................................24

CFTC v. Equity Finance Group, LLC, No. 04 CV 1512, 2005 WL 2143975 (D.N.J. Sept. 2, 2005) .............................52

CFTC v. Topworth Int’l, Ltd., 205 F.3d 1107 (9th Cir. 2000) ............................................................................52

Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837 (1984)......................................................................................46, 47

Cunningham v. Brown, 265 U.S. 1 (1924)..........................................................................................51, 53

Daly v. Deptula (In re Carrozzella & Richardson), 286 B.R. 480 (D. Conn. 2002)............................................................................39

Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008) ..............................................................................40


ii

Drenis v. Haligiannis, 452 F. Supp. 2d 418 (S.D.N.Y. 2006) ..........................................................38, 42

Enron Corp. v. JP Morgan Sec., Inc. (In re Enron Corp.), Nos. M-47 (GBD), 01-6034 (AJG), Adv. Nos. 03-92677 (AJG), 03-92682 (AJG), 2008 WL 281972, at *5 (S.D.N.Y. 2008) ..............................42

Exch. Nat’l Bank of Chicago v. Wyatt, 517 F.2d 453 (2d Cir. 1975) ...............................................................................19

Focht v. Athens (In re Old Naples Sec., Inc.), 311 B.R. 607 (M.D. Fla. Sept. 30, 2002)..........................................25, 33, 35, 52

In re Grafton Partners, L.P., 321 B.R. 527 (B.A.P. 9th Cir. 2005) ..................................................................42

Gredd v. Bear, Stearns Sec. Corp. (In re Manhattan Inv. Fund Ltd.), 310 B.R. 500 (Bankr. S.D.N.Y. 2002)................................................................41

In re Integra Realty Res., Inc., 198 B.R. 352 (D. Colo. 1996), aff'd, 354 F.3d 1246 (10th Cir. 2004) .................................................................41

In re Lake States Commodities, Inc., 253 B.R. 866 (Bankr. N.D. Ill. 2000) .................................................................36

Lustig v. Weisz & Assoc., Inc. (In re Unified Commercial Capital), No. 01-MBK-6004L, 2002 WL 32500567 (W.D.N.Y. June 21, 2002) .......35, 39

In re Manhattan Inv. Fund Ltd., 397 B.R. 1 (S.D.N.Y. 2007) .............................................................38, 40, 42, 43

Merrill v. Abbott (In re Indep. Clearing House Co.), 77 B.R. 843 (D. Utah 1987)................................................................................39

In re New Times Sec. Servs., Inc., 371 F.3d 68 (2d Cir. 2004) ..........................................................................passim

In re New Times Sec. Servs., Inc., 463 F.3d 125 (2d Cir. 2006) .........................................................................34, 35

In re Nortel Networks Corp. Sec. Litig., 539 F.3d 129 (2d Cir. 2008) .........................................................................10, 50

Official Cattle Contract Holders Comm. v. Commons (In re Tedlock Cattle Co.), 552 F.2d 1351 (9th Cir. 1977) ............................................................................52


iii

Pettus v. Morgenthau, 554 F.3d 293 (2d Cir. 2009) ...............................................................................29

Picard v. Taylor (In re Park South Sec. LLC), 326 B.R. 505 (Bankr. S.D.N.Y. 2005)................................................................37

Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995) ..........................................................................36, 39

SEC v. Aberdeen Sec. Co., 480 F.2d 1121 (3d Cir. 1973) .............................................................................25

SEC v. Credit Bancorp, Ltd., No. 99 CIV. 11395, 2000 WL 1752979 (S.D.N.Y. Nov. 29, 2000) aff'd, 290 F.3d 80 (2d Cir. 2002) ..................................................................35, 52

SEC v. F.O. Baroff Co., 497 F.2d 280 (2d Cir. 1974) ...............................................................................19

Sec. Investor Prot. Corp. v. Barbour, 421 U.S. 412 (1975)......................................................................................18, 19

Sec. Investor Prot. Corp. v. Charisma Sec. Corp., 371 F. Supp. 894 (S.D.N.Y.), aff’d, 506 F.2d 1191 (2d Cir. 1974) ...................27

Sec. Investor Prot. Corp. v. Morgan, Kennedy & Co., 533 F.2d 1314 (2d Cir. 1976) .......................................................................27, 50

Sec. Investor Prot. Corp. v. Vigman, 803 F.2d 1513 (9th Cir. 1986) ............................................................................24

Sender v. Buchanan (In re Hedged-Inv. Assoc., Inc.), 84 F.3d 1286 (10th Cir. 1996) ............................................................................39

Sharp Int’l Corp. v. State Street Bank and Trust Co. (In re Sharp Int’l Corp.), 403 F.3d 43 (2d Cir. 2005) .................................................................................42

Simon v. Safelite Glass Corp., 128 F.3d 68 (2d Cir. 1997) .................................................................................50

Skidmore v. Swift & Co., 323 U.S. 134 (1944)......................................................................................47, 49

In re Slatkin, 525 F.3d 805 (9th Cir. 2008) ..............................................................................10

In re Taubman, 160 B.R. 964 (Bankr. S.D. Ohio 1993) ..............................................................39


iv

Terry v. June, 432 F. Supp. 2d 635 (W.D. Va. 2006)................................................................39

Troll Co. v. Uneeda Doll Co., 483 F.3d 150 (2d Cir. 2007) ...............................................................................49

Warfield v. Carnie, No. 04 CV 633, 2007 WL 1112591 (N.D. Tex. Apr. 13, 2007).........................34

Wider v. Wooten, 907 F.2d 570 (5th Cir. 1990) ..............................................................................42

Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589 (9th Cir. 1991) ..............................................................................39

Statutes 11 U.S.C. § 546(e) .............................................................................................40, 42 11 U.S.C. § 548(a)(1)(A) .........................................................................................38 15 U.S.C. § 78ff .........................................................................................................4 15 U.S.C. § 78j(b) ......................................................................................................4 15 U.S.C. § 78o(b) ...................................................................................................11 15 U.S.C. § 78aaa et seq. ...........................................................................................1

§ 78ccc ................................................................................................................18 § 78ccc(a)(1) .......................................................................................................21 § 78ddd................................................................................................................19 § 78ddd(a)(1) ......................................................................................................21 § 78eee(b)(4).........................................................................................................2 § 78-fff(2)(b).................................................................................................28, 47 § 78fff(3)(a) ........................................................................................................21 § 78fff(b) .............................................................................................................19 § 78fff-1(a)............................................................................................................5 § 78fff-2(a)(2) .......................................................................................................6 § 78fff-2(b)...................................................................................................passim § 78fff-2(c)(1) ...............................................................................................20, 21 § 78fff-2(c)(3) .....................................................................................................37


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§ 78fff-3(a)................................................................................................5, 21, 31 § 78fff-3(a)(1) .....................................................................................................21 § 78lll(11).....................................................................................................passim § 78lll(2)........................................................................................................19, 25 § 78lll(4)........................................................................................................19, 20 § 78lll(7)(B) ..........................................................................................................4

28 U.S.C. § 158(d)(2).................................................................................................7 28 U.S.C. § 158(d)(2)(A) ...........................................................................................2

Rules

17 C.F.R. § 240.10b-5................................................................................................4 17 C.F.R. § 300.500 et seq.......................................................................................31 17 C.F.R. § 300.502(a)(1) ........................................................................................31 17 C.F.R. § 300.503(a).............................................................................................37 17 C.F.R. § 300.503(b) ............................................................................................38

Pleadings United States v. DiPascali,

No. 09-CR-764 (S.D.N.Y. Aug. 11, 2009) (RJS)................................................8 United States v. Madoff,

No. 09-CR-213 (S.D.N.Y.) (DC)..........................................................................8


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PRELIMINARY STATEMENT

In December 2008, victims of Bernard Madoff’s multi-billion dollar Ponzi

scheme learned that the double-digit returns that had regularly appeared on their

brokerage statements, in good times and bad, were a fraud. Madoff, rather than

being an investment wizard, had never actually traded in securities, but had

concocted fictitious trades after the fact based upon historical prices. And as is

typical of Ponzi schemes, when customers requested distributions of “profits” from

their accounts, Madoff paid them with money invested by other customers. In

short, they received nothing more than other people’s money.

The Trustee is responsible under the Securities Investor Protection Act, 15

U.S.C. §78aaa et seq. (“SIPA”),1 for identifying, collecting, and distributing

customer property to the customers of Bernard L. Madoff Investment Securities

LLC (“BLMIS”). The appellants argue that the Trustee should have calculated

their “net equity”—which determines their percentage of recovered customer

property—based on the amounts shown on their last customer statements (the “last

statement method”).

But the Trustee properly rejected that method, as everything on those

statements is a fiction. Instead, the Trustee has calculated net equity based upon

the real assets that customers lost to Madoff’s scheme: the cash they deposited,

1 References to SIPA sections hereinafter shall replace “15 U.S.C.” with “SIPA.”


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less any amount they withdrew (the “net investment” or “cash in/cash out”

method). As the bankruptcy court properly held, the net investment method is the

only one consistent with the plain language of SIPA, bankruptcy law, the judicial

treatment of Ponzi schemes, and equity. This conclusion is shared by the SEC and

the Securities Investor Protection Corporation (“SIPC”), whose interpretations of

SIPA the Court should defer to. To do otherwise would contravene SIPA and shift

limited customer funds from those that have recovered nothing to those that

already profited from the scheme.

JURISDICTIONAL STATEMENT

The United States Bankruptcy Court for the Southern District of New York

has jurisdiction over this case under SIPA §78eee(b)(4). The bankruptcy court

issued a decision on March 1, 2010, and an order on March 8, 2010, relating to the

method for calculating net equity. The bankruptcy court certified an immediate

appeal to this Court of its order and decision under 28 U.S.C. § 158(d)(2)(A).

Various notices of appeal and petitions for permission were filed with this Court,

and on June 16, 2010, this Court accepted jurisdiction of this direct appeal.

STATEMENT OF THE ISSUES

1. “Net equity” under SIPA is the amount a debtor would have owed to a

customer if the debtor liquidated the securities positions of the customer, as well as

cash deposited to purchase securities. The customers of Madoff’s Ponzi scheme


3

had no securities positions that could have been liquidated. Did the bankruptcy

court correctly conclude that net equity had to be calculated based upon the cash

that customers deposited with the debtor?

2. A SIPA trustee has an obligation to discharge net equity claims only

to the extent that they are supported by the debtor’s books and records or otherwise

are established to the trustee’s satisfaction. The books and records show that the

customers’ account statements were wholly fictional, as they reflected stock trades

that never occurred—and that never could have occurred, because they were

fabricated based on historical stock prices. Did the bankruptcy court correctly

reject the argument that net equity should be based upon those fictitious customer

statements, without any reference to the debtor’s books and records that showed

what actually occurred?

3. The SEC and SIPC agree with the Trustee and the bankruptcy court

that net equity should be calculated based upon customers’ net cash investments,

not based upon their last account statements. This Court has previously deferred to

joint interpretations of SIPA by the SEC and SIPC. Should the Court defer to their

joint interpretation of SIPA here as well, particularly since their interpretation is

the only one consistent with the plain language of SIPA, this Court’s prior

jurisprudence, the Trustee’s avoidance powers, the historical treatment of Ponzi

schemes, and equity?


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STATEMENT OF THE CASE

On December 11, 2008, Madoff was charged with a multi-billion dollar

securities fraud scheme in violation of 15 U.S.C. §§ 78j(b) & 78ff and 17 C.F.R.

§ 240.10b-5 in the United States District Court for the Southern District of New

York. See In re Bernard L. Madoff Inv. Securities LLC, 424 B.R. 122, 125-26

(Bankr. S.D.N.Y. 2010) (“In re BLMIS”). Also on December 11, 2008 (the “Filing

Date”),2 the SEC filed a civil complaint against Madoff and BLMIS, among others,

alleging that they were operating a Ponzi scheme through BLMIS’s investment

advisor activities. See In re BLMIS, 424 B.R. at 124 n.3, 126.

On December 15, 2008, SIPC filed an application in the civil action alleging

that BLMIS was not able to meet its obligations to securities customers as they

came due and that its customers needed the protection afforded by SIPA. The SEC

consented to combining its action with SIPC’s action. The district court granted

SIPC’s application, appointed Irving H. Picard as trustee for the liquidation of

BLMIS, and referred the case to the bankruptcy court. In re BLMIS, 424 B.R. at

126.

A SIPA trustee is responsible for recovering and distributing customer

property to a broker’s customers, assessing claims, and liquidating any other assets

2 The Filing Date is the date the SEC commenced its suit against BLMIS, resulting in the appointment of a receiver. See SIPA § 78lll(7)(B).


5

of the firm for the benefit of the estate and its creditors. Under section 78fff-1(a)

of SIPA, a SIPA trustee has the general powers of a bankruptcy trustee, in addition

to the powers granted by SIPA. The Trustee has recovered a billion and a half

dollars for the benefit of the estate’s customers and creditors to date,3 but does not

expect that the total value of assets ultimately recovered will be sufficient to fully

reimburse the customers of BLMIS for the many billions of dollars they invested

with BLMIS over the years.

The statutory framework for the satisfaction of customer claims in a SIPA

liquidation proceeding provides that customers share pro rata in customer property

to the extent of their “net equity,” as defined in section 78lll(11) of SIPA. For each

customer with a valid net equity claim, if the customer’s ratable share of customer

property is insufficient to make him whole, SIPC advances funds to the SIPA

trustee up to the amount of the customer’s net equity. SIPA § 78fff-3(a).

However, the amount of the SIPC advance is capped at $500,000 for claims for

securities (which these claims are). Id.

On December 23, 2008, the bankruptcy court entered a claims procedure

order specifying the procedures for filing, determining, and adjudicating customer

claims. In re BLMIS, 424 B.R. at 126. The order provided that under section

78fff-2(a)(2) of SIPA, claims would be filed with the Trustee, who would 3 See Bankruptcy Docket (“B.Dkt”) 2207, p.4.


6

determine the claims in writing, and claimants who opposed the Trustee’s

determination would file objections in the bankruptcy court for judicial resolution.

Id.

The Trustee determined each customer’s net equity using the “net

investment method” (aka the “cash in/cash out method”). This method assesses a

customer’s actual net deposits in the scheme, calculating the total amount

deposited by the customer into her BLMIS account, and subtracting any amounts

withdrawn from her account. Certain claimants objected, arguing that net equity

should be calculated instead based upon the fictitious amounts shown on their last

account statements—the “last statement method.” In re BLMIS, 424 B.R. at 126.

The Trustee moved the bankruptcy court for a briefing schedule and hearing

on the matter. B.Dkt 395. After hearing on the motion, the bankruptcy court

issued its scheduling order, which provided for a briefing schedule and hearing on

the limited question of whether net equity under SIPA should be calculated under

the net investment method or the last account statement method. Joint Appendix

Vol. (“J.A.V.”) I, 267.

The Trustee filed his brief on October 16, 2009, with accompanying

declarations. J.A.V. I, 270-537. SIPC and the SEC filed briefs agreeing that net

equity should be calculated based upon customers’ net investments, not their


7

fictitious last statements. B.Dkt. 519, 1052, 1765, 1768.4

On March 1, 2010, the bankruptcy court issued a decision endorsing the

Trustee’s use of the net investment method, and entered an order to that effect on

March 8, 2010. J.A.V. III, 547-603. The bankruptcy court, pursuant to a joint

request of the Trustee and certain claimants, and on the bankruptcy court’s own

motion, certified an immediate appeal to this Court under 28 U.S.C. § 158(d)(2).

This Court elected to hear this appeal on June 16, 2010.

STATEMENT OF FACTS

A. The Relevant Facts Are Not In Dispute.

The Trustee and most appellants agree that the facts relevant to this appeal

are not in dispute. See, e.g., Sterling Equities Br. (Doc. 185, at 6); Berman Br.

(Doc. 204, at 5); Peskin Br. (Doc. 215, at 7).5 The relevant undisputed facts are

these: (1) Madoff and his coconspirators orchestrated a multi-year Ponzi scheme

in which they pretended to trade in securities but failed to make the purchases and

sales reflected on customer account statements; (2) BLMIS falsified securities

transactions reflected on customer statements by creating phony transactions after

4 The SEC took the position that the net investment method should incorporate an adjustment for inflation. That question was not within the scope of the briefing, and will be addressed by the bankruptcy court at a later date. See In re BLMIS, 424 B.R. at 125 n.8. 5 For ease of reference, briefs are referred to by the first appellants and appellate docket number.


8

the fact based on historical market data; and (3) BLMIS funded customer

withdrawals with cash deposited by other customers.

These facts can be gleaned from the plea colloquies of Madoff and his right-

hand man, Frank DiPascali, Jr. Madoff marketed a “split-strike conversion”

strategy that appeared to generate remarkably consistent and above-average returns

for his customers. But as Madoff admitted, “I never made those investments I

promised clients[.]” Plea allocution of Bernard L. Madoff, United States v.

Madoff, No. 09-CR-213 (DC) (S.D.N.Y.) J.A.V. II 290, 291 (“Madoff

Allocution”). As DiPascali explained: “From at least the early 1990’s through

December of 2008, there was one simple fact that Bernie Madoff knew, that I

knew, and that other people knew but that we never told the clients nor did we tell

the regulators like the SEC. No purchases of [sic] sales of securities were actually

taking place in their accounts. It was all fake. It was fictitious. . . .” Plea

allocution of Frank DiPascali, United States v. DiPascali, No. 09-CR-764 (RJS)

(S.D.N.Y. Aug. 11, 2009), J.A.V. I, 319, 365 (“DiPascali Allocution”).

Instead, investors’ funds were principally deposited into a bank account at

J.P. Morgan Chase (the “703 Account”). See Madoff Allocution, J.A.V. II at 291;

DiPascali Allocution, J.A.V. I at 366. The money received from customers was

not invested in securities for the benefit of those customers as purported, but

instead was primarily used to make distributions to, or payments on behalf of,


9

other investors, as well as withdrawals and payments to Madoff family members

and employees. See Madoff Allocution, J.A.V. II at 291-92, 295; DiPascali

Allocution, J.A.V. I at 365-66, 375-76, 378.

As Madoff explained at his plea hearing, “Up until I was arrested . . . I never

invested [customer] funds in the securities, as I had promised. Instead, those funds

were deposited in [the 703 Account]. When clients wished to receive the profits

they believed they had earned with me or to redeem their principal, I used the

money in the [703 Account] that belonged to them or other clients to pay the

requested funds.” Madoff Allocution, J.A.V. II at 291-92; see also DiPascali

Allocution, J.A.V. I at 366.

Madoff, DiPascali, and their cohorts dummied up customer statements to

appear as if securities were being traded and as if profits were being generated.

They combed through historical stock prices and concocted “profitable” trades

after the fact to mirror the profit Madoff had promised. As DiPascali explained,

“[o]n a regular basis, I used hindsight to file historical prices on stocks then I used

those prices to post purchase of sales [sic] to customer accounts as if they had been

executed in real-time. On a regular basis I added fictitious trade data to account

statements of certain clients to reflect the specific rate of return that Bernie Madoff


10

had directed for that client.” DiPascali Allocution, J.A.V. I at 366.6

The Trustee also submitted the Declaration of Joseph Looby,7 whose firm

was retained by the Trustee to assist in investigating the BLMIS books and records

and the nature and scope of the fraud. The Looby Declaration corroborates the

Madoff and DiPascali allocutions and sets forth in great detail the Trustee’s

investigation of Madoff’s Ponzi scheme.8

B. The Structure Of BLMIS And Its Collapse.

BLMIS is a New York limited liability company wholly owned by Madoff

and run by him together with several Madoff family members and a number of

employees. BLMIS had three business units: market making, proprietary trading,

6 One appellant argues that these allocutions are unreliable. See Rynne Br. (Doc. 220, at 20). But a plea allocution is competent evidence for a court to consider, see, e.g., In re Slatkin, 525 F.3d 805, 811-12 (9th Cir. 2008) (plea agreement admissible under Fed. R. Evid. 807 as evidence of operation of Ponzi scheme), and Rynne did not object to the admission of the allocutions below or present any evidence to the contrary. Another appellant argues that the bankruptcy court improperly took judicial notice of the allocutions and the Looby Declaration. See Malibu Trading (Doc. 177, at 11-13). But the Court did not take judicial notice; it ruled based upon submitted evidence that was undisputed or to which no appellant objected. See Fed. R. Civ. P. 43(c) (motions may be heard and decided upon affidavits, applicable to bankruptcy cases under Fed. R. Bankr. P. 9017). In any event, Malibu Trading did not raise the judicial notice argument below, waiving the issue. See In re Nortel Networks Corp. Sec. Litig., 539 F.3d 129, 132 (2d Cir. 2008) (per curiam) (“an appellate court will not consider an issue raised for the first time on appeal”). 7 J.A.V. I, 501-37. 8 Certain appellants complain that they were not permitted discovery. But no appellant sought to include discovery in the briefing schedule for the net equity motion, nor did the Bankruptcy Court prohibit such discovery in general. Only one appellant, Lawrence Velvel, actually served discovery, and his discovery was directed at “the motive of SIPC and the Trustee in using [cash-in cash-out] instead of final statements.” (Docket 242 at 29) (emphasis added). The motives of the Trustee and SIPC are irrelevant to the determination of the net equity issue.


11

and investment advisory. In re BLMIS, 424 B.R. at 127. BLMIS registered with

the SEC as a broker-dealer on January 19, 1960 under § 15(b) of the Securities

Exchange Act of 1934, 15 U.S.C. § 78o(b)), and, beginning in 2006, as an

investment adviser (“IA Business”). As a registered broker-dealer, BLMIS was a

member of SIPC. In re BLMIS, 424 B.R. at 127.

While the business units were financially interconnected, the proprietary

trading and market making desks of BLMIS were largely run as enterprises

separate and apart from the IA Business. Id. at 127. The market making and

proprietary trading business units engaged in real trading for the account of

BLMIS, using live computer systems and trading platforms that interfaced with

third-party feeds and outside data sources necessary for trading. Id. They were

subject to compliance and risk monitoring programs by the exchanges they traded

on, the clearing houses they utilized, and the National Association of Securities

Dealers (“NASD”) and its successor, Financial Industry Regulatory Authority

(“FINRA”). Id. These businesses appear to have been largely conducted as

legitimate, if ultimately unprofitable, enterprises. Id. From at least 2007 forward,

Madoff used proceeds of the fraudulent IA Business to prop up these business

units. Id. at 128.

Madoff operated the IA Business from the 17th floor of the BLMIS offices

at 885 Third Avenue with a cadre of employees as a closed system under heavy


12

secrecy. Outwardly, BLMIS functioned as both an investment adviser to its

customers and a custodian of their securities. Id. at 127 & n.14. Its annual audits

were purportedly performed by Friehling & Horowitz, CPAs, P.C., an accounting

firm with three employees (one of whom was semi-retired) with offices in a strip

mall. Id. at 127. The precise date on which BLMIS began purportedly engaging in

investment advisory services has not been established, but it appears that BLMIS

was offering such services as far back as the 1960s. Id. BLMIS appears never to

have acted as a true investment adviser in the interest of its customers. Id.

Madoff solicited billions of dollars from investors for his fraudulent IA

Business, shunning publicity, excluding some investors while affording others the

privilege of investing with him, and often requiring confidentiality in exchange for

being accorded the benefit of his apparent investment acumen. The final customer

statements issued by BLMIS as of November 30, 2008 falsely record nearly $64.8

billion of net investments and related fictitious gains from those investments with

BLMIS as of the Filing Date. Id. at 124.

Instead of investing the money in securities as promised, Madoff used the

money to perpetuate the scheme by distributing it to other investors, as well as to

enrich Madoff family members and employees. Id. at 128. The Ponzi scheme

worked as planned until, inevitably, customers’ requests for redemptions

overwhelmed the flow of new investments and caused the collapse of the scheme


13

in December 2008. Id. On June 29, 2009, Madoff was sentenced to 150 years

incarceration for his crimes. Id. at 126.

C. The Fraudulent Scheme.

The IA Business was staffed by more than 25 employees and was directed

on a day-to-day basis by Madoff and DiPascali. Id. at 127 & n.14. Given its

physical isolation on the 17th floor, Madoff could limit access to certain key

employees and insiders. Id. at 127.

For most customers, Madoff purported to use a “split-strike conversion”

strategy, in which several times a year he would time the market by investing

customer funds in a subset (or “basket”) of large cap common stocks that

comprised the Standard & Poor’s 100 Index, then later (including the end of each

quarter) sell all baskets and invest in T-bills or other money market funds, and cash

reserves. Id. at 129. By purporting to liquidate the split-strike security basket

positions by quarter end, the equities in the baskets were not required to be

disclosed in SEC Form 13F. Id. at 129-30. BLMIS also purported to hedge its

transactions by purchasing and selling related S&P 100 index option contracts,

thereby controlling both the downside risk associated with possible adverse price

changes in the basket of stocks and limiting profits associated with increases in

underlying stock prices. Id. at 130.

None of these investment strategies were ever implemented. The trades,


14

order tickets, customer statements, and other records created in furtherance of the

fraud were fabricated. Id. at 130. To create the illusion that these stocks had been

purchased or sold, BLMIS employees would compile historical price and volume

data for each stock selected within the basket, and use this historical information to

fabricate stock transactions. Id. With the benefit of backdating, Madoff and his

employees at BLMIS were able to consistently “generate” purported annual returns

of between 10 and 17% for “split-strike conversion” customers. Id.

The vast majority of the BLMIS customer accounts were purportedly

invested in the split-strike conversion strategy, and DiPascali had primary

responsibility for those accounts. About 5% of the customers, however, had non-

split-strike conversion accounts. Id. at 131. These included long-time customers,

such as Stanley Chais, Jeffry Picower, and the customer accounts held by various

Madoff family members and employees. Id. These accounts reported even greater

rates of return, in excess of the 10-17% “profits” that the split-strike strategy

accounts received. Id. These customers were handled on an account-by-account

basis. Id. But the essence of the fraud was the same: false customer statements

were generated based on after-the-fact selections of stock “trades” using already

published trading data. With the exception of a few isolated trades and physical

custody of a very limited number of securities entrusted to BLMIS by certain

customers, no trading occurred for these accounts either. Id.


15

D. Investments In The BLMIS Fund.

When opening their BLMIS customer accounts, customers signed

standardized customer agreement documents, in which they relinquished all

investment authority to Madoff. In essence, customers deposited their cash and

were able to make withdrawals upon request, but ceded to Madoff all other rights

associated with their accounts, including the authority to make investment

decisions. Id. at 128.

A customer’s individual dealings with BLMIS were generally in cash.

Customers, with minor exceptions, never directed the purchase or sale of specific

securities. Id. The 703 Account at Chase was little more than a slush fund for

Madoff and the other individuals who benefited from the Madoff Ponzi scheme.

Customer funds were deposited into the account and, when requested, withdrawals

were paid to customers from this account. Id. at 129. Balances in the account at

the end of each business day were transferred to affiliated overnight investment

accounts at Chase to purchase treasuries or other short-term paper until additional

monies were needed to fund additional withdrawal requests by customers, capital

needs of the broker-dealer operation of BLMIS, or Madoff’s (and other insiders’)

personal needs. Id. But at all relevant times, the purported monthly equity

balances of the BLMIS customer accounts far exceeded the amount of capital

deposited in the 703 Account. Id. at 129.


16

E. Generation Of Customer Statements.

Information relating to BLMIS customer accounts was stored in a computer

system, the “AS/400,” on the 17th floor. Id. at 131. The computer system was

programmed to record the fictitious securities positions allegedly bought and sold,

customer cash transactions, prepare BLMIS customer statements, and produce

BLMIS trade confirmations. Id. The computer had software that could be utilized

to enter a “basket” of fictitious “trades” with any desired price or trade date that

could then be allocated, pro rata, to the various BLMIS customer accounts residing

within the database. Id. The computer was not programmed or enabled to

communicate, facilitate, or execute trading of any kind. Id. And none of the split

strike trades entered into the computer were reconciled (or reconcilable) with the

Depository Trust & Clearing Corporation (“DTCC”), which serves as a custodian

for most stock and government debt securities issued in the United States. Id. at

131 & n.21.

BLMIS did not provide its customers with electronic real-time online access

to their accounts, which by the year 2000 was customary in the industry. Id. at

131. The use of outmoded mailed paper statements facilitated the scheme by

allowing BLMIS more time to alter trading records and delay the delivery of

information. Id. at 131-32.


17

F. BLMIS Customers’ Investments Were Never Exposed To The Risks Of Market Trading, And The “Profits” Were Fictional.

The trades reflected on BLMIS customer statements and confirmations were

fake; only the cash deposits to and withdrawals from the particular customer

account reflected events that actually occurred. Id. at 128. The trades were

fictitious not only because they did not occur, but because they could not have

occurred—they were created after the fact using historical market prices.

Customer funds were thus never exposed to the risks associated with market

trading. Id. As the bankruptcy court held, “[g]iven that in Madoff’s fictional

world no trades were actually executed, customer funds were never exposed to the

uncertainties of price fluctuation, and account statements bore no relation to the

United States securities market at any time.” Id.

These trades also could not have occurred because customers lacked the

money to pay for them; while initial deposits made by BLMIS customers may have

been sufficient to cover the initial fake “purchase” of securities reported on the

BLMIS customer statements, without additional customer deposits any subsequent

“purchases” of equal or greater nominal value could generally only be afforded by

virtue of the fictional “profits” recorded on customer statements. Id.

Consequently, not only were the securities purchases imaginary, the payments for

those securities purchases were equally imaginary, except to the extent of the

actual net cash deposits provided by the customer. Id.


18

On certain occasions, the fabricated transactions that showed up on customer

statements did not involve real securities or possible trades. For example, one of

the money market funds in which customer resources were purportedly invested

was the Fidelity Brokerage Services LLC’s “Fidelity Spartan U.S. Treasury Money

Market Fund.” But Fidelity has acknowledged that from 2005 onwards, the

organization no longer offered participation in a fund of that name. Id. at 130.9

And in various instances, trades reported on customer statements were outside the

dollar range for that security on that day. Id. “At bottom, the BLMIS customer

statements were bogus and reflected Madoff’s fantasy world of trading activity,

replete with fraud and devoid of any connection to market prices, volumes, or other

realities.” Id.

G. SIPA, SIPC, And Net Equity.

Congress enacted SIPA to stem the failure of brokerage houses, restore

investor confidence in capital markets after a period of business contraction, and

upgrade financial responsibility requirements for registered broker-dealers. Sec.

Investor Prot. Corp. v. Barbour, 421 U.S. 412, 415 (1975). Under SIPA,

Congress also created SIPC, a nonprofit, private membership corporation to

which most registered broker-dealers are required to belong. See SIPA § 78ccc.

9 Certain appellants dismiss the significance of this fact, citing evidence that the name of the fund changed in 2005. But none refute the fact that customer statements falsely set forth investments in a fund that did not exist after 2005.


19

The SIPC Fund, a congressionally mandated protection program, is authorized

under section 78ddd of SIPA and is designed to protect the customers of SIPC

member broker-dealers from loss in case of the financial failure of a SIPC-

member brokerage house. “The object of [SIPA], and the function of the [SIPC]

it created, is to protect the public customers of securities dealers from suffering

the consequences of financial instability in the brokerage industry.” SEC v. F.O.

Baroff Co., 497 F.2d 280, 281 (2d Cir. 1974).

SIPA created a new form of liquidation proceeding applicable only to SIPC

member firms and designed to return promptly customer property. See Barbour,

421 U.S. at 416. A liquidation under SIPA is essentially a bankruptcy proceeding

“tailored to achieve SIPA’s objectives.” In re BLMIS, 424 B.R. at 133; see Exch.

Nat’l Bank of Chicago v. Wyatt, 517 F.2d 453, 457-459 (2d Cir. 1975); SIPA

§ 78fff(b) (SIPA liquidation proceeding shall proceed as if conducted under

Chapter 7 of Bankruptcy Code to extent consistent with SIPA).

Under SIPA, a fund of “customer property” is established, separate from the

general estate, for priority distribution to the “customers” of the debtor. See SIPA

§ 78lll(4) (defining “customer property”); SIPA § 78lll(2) (defining “customer”).

Those who fit the definition of “customer” under SIPA are accorded preferential

treatment in the form of a priority over general creditors in both the distribution

from the fund of customer property and the funds advanced by SIPC. See In re


20

A.R. Baron & Co., 226 B.R. 790, 795 (Bankr. S.D.N.Y. 1998) (“‘Customer’ status

in a SIPA proceeding is a preferred status which gives customers priority in the

distribution of certain assets marshaled by the trustee as well as entitlement to

advances from the SIPC fund.”); In re Adler, Coleman Clearing Corp., 216 B.R.

719, 722 (Bankr. S.D.N.Y. 1998) (“A person whose claim against the debtor

qualifies as a ‘customer claim’ receives preferential treatment in the distribution of

assets from the debtor’s estate”); SIPA §§ 78fff-2(b), 78fff-2(c)(1), 78lll(4).

Each customer is entitled to share in the fund of customer property pro rata

to the extent of his “net equity.” “Net equity” is defined in relevant part as

follows:

The term ‘net equity’ means the dollar amount of the account or accounts of a customer, to be determined by –

(A) calculating the sum which would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase on the filing date, all securities positions of such customer . . . ; minus

(B) any indebtedness of such customer to the debtor on the filing date[.]

SIPA § 78lll(11). Section 78fff-2(b) of SIPA further provides that a SIPA trustee

must discharge net equity claims only “insofar as such obligations are ascertainable

from the books and records of the debtor or . . . otherwise established to the

satisfaction of the trustee.”

SIPA also provides for the establishment of a SIPC fund to advance money

to the SIPA trustee for prompt payment of valid net equity claims. See SIPA


21

§§ 78ddd(a)(1), ccc(a)(1), fff(3)(a). When customers have claims for securities, as

here, SIPC advances for each customer with a valid net equity claim the amount of

that customer’s net equity, as needed, up to $500,000. See SIPA § 78fff-3(a)(1). If

the advance taken together with the subsequent distribution of customer property

exceeds the customer’s net equity, SIPC recoups the excess. SIPA §§ 78fff-3(a),

2(c)(1).

SUMMARY OF THE ARGUMENT

“Net equity” under SIPA is the amount a debtor would have owed to a

customer if the debtor liquidated the securities positions of the customer, as well as

cash deposited to purchase securities. The customers of Madoff’s Ponzi scheme

had no securities positions that could have been liquidated. Accordingly, the

bankruptcy court correctly concluded that net equity had to be calculated based

upon the cash that customers deposited with the debtor, not nonexistent securities

positions.

Moreover, a SIPA trustee has an obligation to discharge net equity claims

only to the extent that they are supported by the debtor’s books and records or

otherwise are established to the trustee’s satisfaction. The books and records show

that the customers’ account statements were wholly fictional, as they reflected

stock trades that never occurred and that never could have occurred, because they

were fabricated after the fact based on historical stock prices and financed by


22

nonexistent profits. The bankruptcy court thus properly rejected the argument that

net equity should be based upon those fictitious customer statements, without any

reference to the debtor’s other books and records.

Should the plain language of SIPA not unambiguously direct this

conclusion, this Court should defer to the well reasoned joint conclusion of the

SEC and SIPC that net equity should be calculated using the net investment

method, not the last statement method. This Court has previously deferred to joint

interpretations of SIPA by the SEC and SIPC, and should do so here as well,

particularly given the fact that their joint position is the only one consistent with

the plain language of SIPA, this Court’s prior jurisprudence, the Trustee’s

avoidance powers, the historical treatment of Ponzi schemes, and equity.

ARGUMENT

I. STANDARD OF REVIEW.

This Court reviews de novo the bankruptcy court’s interpretation of SIPA.

In re New Times Sec. Servs., Inc., 371 F.3d 68, 75 (2d Cir. 2004) (“New Times I”).

II. UNDER THE PLAIN LANGUAGE OF SIPA, NET EQUITY SHOULD BE BASED UPON CUSTOMERS’ NET INVESTMENTS, NOT THE FICTITIOUS AMOUNTS SHOWN ON THEIR LAST STATEMENTS.

A. The Last Statements Did Not Reflect Securities Positions That Could Have Been Liquidated As Of The Filing Date.

Under section 78lll(11) of SIPA, “net equity” requires “calculating the sum

which would have been owed by the debtor to such customer if the debtor had


23

liquidated, by sale or purchase on the filing date, all securities positions of such

customer (other than customer name securities reclaimed by such customer)[.]”

See New Times I, 371 F.3d at 76 (defining “net equity” as “the sum [the Claimants]

would have been owed by the Debtors if the Debtors had liquidated, on the filing

date, all of the Claimants’ securities positions.”).

The appellants contend that the plain language of SIPA mandates using their

last customer statements to calculate their net equity. But the plain language of

this definition supports the Trustee’s use of the net investment method, not

customers’ fictitious last statements, because the customer statements do not reflect

“securities positions” that could have been “liquidated” on the filing date.

The appellants argue that their last account statements show their “securities

positions.” They do not. As Madoff (with a few exceptions) did not purchase the

securities reflected on BLMIS customer statements, the final customer statements

do not reflect real securities positions. Rather, the amounts set forth on their last

account statements were fabricated by Madoff, DiPascali and others. As the

bankruptcy court found, securities positions were “nonexistent.” In re BLMIS, 424

B.R. at 135. And the trades set forth those statements could never have existed, as

they were concocted after-the-fact, without any exposure to market risk, and were

“paid for” solely by other nonexistent transactions.


24

Moreover, net equity is not defined under section 78lll(11) as a customer’s

“securities positions.” It is defined as what “would have been owed by the debtor”

to a customer “if the debtor had liquidated, by sale or purchase on the filing date,

all securities positions of such customer.” Id. (emphasis added). See New Times I,

371 F.3d at 72 (quoting this provision); Sec. Investor Prot. Corp. v. Vigman, 803

F.2d 1513, 1516 (9th Cir. 1986) (net equity “is the amount that the broker would

have owed each customer had it liquidated all the customer’s holdings on the date

the SIPC filed for a protective decree, less any outstanding debt the customer owed

to the broker”); In re Bevill, Bresler & Schulman, Inc. 59 B.R. 353, 363 (D.N.J.

1986) (“As defined in § 78[lll(11)], a customer’s net equity equals the liquidated

value of the customer’s account on the filing date (excluding customer name

securities) minus any indebtedness of the customer to the broker on the filing

date.”).

Thus, by its plain language, net equity is based upon securities positions that

could have been liquidated. And the appellants’ fictitious securities positions

cannot be liquidated, as nonexistent securities cannot be reduced to cash. And it

would be improper to treat these nonexistent securities as if they could be reduced

to cash, given that the trades could never have occurred in the marketplace.

In sum, net equity is narrowly defined as what “would have been owed” had

the “securities positions” of the customer been “liquidated.” And what “would


25

have been owed” to customers had the purported “securities positions” on their last

statements been “liquidated” is zero. As the bankruptcy court properly determined

below, “[t]he account statements are entirely fictitious, do not reflect actual

securities positions that could be liquidated, and therefore cannot be relied upon to

determine Net Equity.” In re BLMIS, 424 B.R. at 135.

This does not mean, however, that the customers’ net equity is zero. As this

Court held in New Times I, net equity also includes the net cash that customers

placed with BLMIS to purchase securities, as section 78lll(2) of SIPA defines

“customer” to include “any person who has deposited cash with the debtor for the

purpose of purchasing securities.” See New Times I at 76 (“Because here there

were no securities to liquidate, the Trustee had to value the claims according to the

amount of ‘cash’ that the Claimants initially paid to the Debtors for their

investments in the New Age Funds”); see also id. at 89 (net equity includes cash

deposited with the debtor to purchase securities); SEC v. Aberdeen Sec. Co., 480

F.2d 1121, 1127 (3d Cir. 1973) (“[Section 78lll(11)] does not make it crystal clear

that the customer’s net equity consists of both his cash balance and the securities

account valued as of the filing date. We have no doubt, however, that the ‘dollar

amount” of a customer’s account includes his cash which the broker has or should

have been holding.’) (cited in New Times I); Focht v. Athens (In re Old Naples

Sec., Inc.), 311 B.R. 607, 617 (M.D. Fla. Sept. 30, 2002) (calculating net equity


26

based on claimants’ investment in Ponzi scheme, offset by phony interest

payments received) (cited in New Times I).

Thus, under the plain language of section 78lll(11), only customers’ net cash

investment is relevant for net equity purposes. As no securities were ever

purchased, or could have been purchased as represented, the bankruptcy court

correctly upheld the calculation of net equity based upon each customer’s net

investment.10

Some appellants suggest that section 78lll(11) defines “net equity” as the

securities positions “owed” by BLMIS to its customers, and argue that the

customer statements establishes what BLMIS legally “owes” them under state and

federal law. See, e.g., Sterling Equities, Doc. 185 at 8 (“The definition of ‘net

equity’ requires that a customer’s claim against a failed broker be calculated by

valuing the securities ‘owed’ to the customer on the filing date.”); id. at 9 (The

“November 30, 2008 account statements . . . reflect the securities positions that

BLMIS owed them as of that date.”).

But “net equity” is not defined as what Madoff or BLMIS may or may not

have “owed” his defrauded customers under state law or other provisions; it is

10 Some appellants contend that the net investment method conflicts with the requirement that net equity be calculated “as of the filing date,” because the Trustee considers cash transfers over the life of an account. But the net investment method values the net investment of a customer as of the filing date, so there is no conflict.


27

narrowly defined to include only “securities positions” that could have been

liquidated on the filing date. See In re Adler, Coleman Clearing Corp., 195 B.R.

266, 273 (Bankr. S.D.N.Y. 1996) (net equity claim has a “narrow scope”). Indeed,

SIPA is not designed to make customers whole for the losses occasioned by fraud.

See Sec. Investor Prot. Corp. v. Morgan, Kennedy & Co., 533 F.2d 1314, 1317 n.4

(2d Cir. 1976) (“SIPA was not designed to provide full protection to all victims of

a brokerage collapse.”); Sec. Investor Prot. Corp. v. Charisma Sec. Corp., 371 F.

Supp. 894, 899 n.7 (S.D.N.Y.) (general contract and fraud claims not included in

umbrella of SIPA protections), aff’d, 506 F.2d 1191 (2d Cir. 1974); In re Adler,

Coleman Clearing Corp., 195 B.R. at 273 (“SIPC’s role in a SIPA liquidation is

limited by statute; it does not attempt to make all customers whole.”).

B. The “Books and Records” Provision Of SIPA Supports The Net-Investment Method Of Calculating Net Equity.

While the appellants claim that the plain language of SIPA supports their

position, nothing in the definition of “net equity” dictates that “securities

positions” must be based upon customer statements, much less fraudulent ones.

The words “customer statements” are nowhere found in SIPA. If a customer’s last

statement reflected actual securities positions—i.e., securities that the customer

ordered and paid for—that statement might well be evidence of his net equity. But

the statements in this case are fictitious from top to bottom.


28

Indeed, the Trustee’s responsibility in distributing the remaining property in

a Ponzi scheme is not to blindly follow fraudulent customer statements, but to

conduct a forensic analysis of all of the books and records of the scheme to

determine the appropriate distribution of customer property. Section 78fff-2(b) of

SIPA provides that a SIPA trustee, upon receipt of a customer claim, must

discharge net equity claims only “insofar as such obligations are ascertainable from

the books and records of the debtor or . . . otherwise established to the satisfaction

of the trustee.”11

Viewed in their entirety, the books and records of the debtor reveal that the

last statements are a fiction. The securities listed on them were never purchased,

and the fictitious backdated transactions reflected on the statements never could

have been replicated in the marketplace. The only real figures reflected in BLMIS

11 Some appellants argue that the use of the term “obligations” in this section supports the use of the last customer statements to calculate net equity. But this term adds nothing to the analysis. Reading section 78fff-2(b) in its entirety reveals that Congress used the term as a shorthand for “net equity claims” (and obligations of the debtor):

After receipt of a written statement of claim . . . the trustee shall promptly discharge, in accordance with the provisions of this section, all obligations of the debtor to a customer relating to, or net equity claims based upon, securities or cash, by the delivery of securities or the making of payments to or for the account of such customer . . . insofar as such obligations are ascertainable from the books and records of the debtor or are otherwise established to the satisfaction of the trustee.

Other appellants take a different tack, arguing that the “books and records” requirement applies only to “obligations” and not to “net equity claims.” This is an unreasonable reading of this provision, because the “insofar” phrase modifies both the “obligations” and “net equity claims” language preceding it.


29

books and records are the customers’ deposits to and withdrawals from their

accounts. Accordingly, the Trustee properly discharged net equity claims on this

basis, reflecting customers’ investment positions untainted by fraud. As the

bankruptcy court properly found, “Because ‘securities positions’ are in fact

nonexistent, the Trustee cannot discharge claims upon the false premise that

customers’ securities positions are what the account statements purport them to be.

Rather, the only verifiable amounts that are manifest from the books and records

are the cash deposits and withdrawals.” In re BLMIS, 424 B.R. at 135.

Certain appellants argue that the definition of “net equity” should be viewed

in a vacuum, without any reference to the “books and records” provision. As a

preliminary matter, even when viewed in isolation the plain language of the “net

equity” definition does not support the appellants’ position, in that their customer

statements do not reflect securities positions that can be liquidated.

In any event, the bankruptcy court was correct that “the definition of Net

Equity under SIPA section 78lll (11) must be read in tandem with SIPA section

78fff-2(b),” 424 B.R. at 135, because basic principles of statutory construction

support reading the provisions together. “The meaning of a particular section in a

statute can be understood in context with and by reference to the whole statutory

scheme, by appreciating how sections relate to one another.” Auburn Hous. Auth.

v. Martinez, 277 F.3d 138, 144 (2d Cir. 2002); see also Pettus v. Morgenthau, 554


30

F.3d 293, 297 (2d Cir. 2009) (“when construing the plain text of a statutory

enactment, we do not construe each phrase literally or in isolation. Rather, we

attempt to ascertain how a reasonable reader would understand the statutory text,

considered as a whole.”). And when viewed together, the appellants’ construction

of net equity—that a SIPA trustee must discharge its net equity claims based solely

on the debtor’s fraudulent records, and not on its accurate records—cannot be

defended.

III. THE APPELLANTS HAVE NO LEGITIMATE EXPECTATIONS IN THE PROFITS OF A PONZI SCHEME.

A. Net Equity Is Not Based Upon Customer Expectations.

Some appellants argue that they have a “legitimate expectation” in the

amounts shown on their final account statements, and that SIPA requires that

expectation to be vindicated. But the definition of “net equity” in SIPA does not

include a concept of “legitimate expectations.” Indeed, the phrase “legitimate

expectations” cannot be found anywhere in SIPA. Rather, the net equity definition

speaks of securities positions that can be liquidated, and of net-equity claims that

can be ascertained from the books and records of the debtor or otherwise to the

satisfaction of the trustee. See SIPA §§ 78lll(11), 78fff-2(b).

The appellants argue that New Times I supports their claim that the net

equity is grounded in a customer’s “legitimate expectations.” Not so. This Court’s

discussion of “legitimate expectations” in New Times I revolved not around net


31

equity, but around the Series 500 Rules, which govern whether a customer has a

claim for cash or securities—something that affects whether the SIPC advance to

which a customer is entitled is capped at $100,000 or $500,000. See SIPA § 78fff-

3(a); 17 C.F.R. § 300.500 et seq.

In New Times I, certain investors in a Ponzi scheme were fraudulently

induced to purchase nonexistent money market funds, and their statements

reflected phony interest payments. 371 F.3d at 71-72. This Court affirmed the

district court’s determination that these customers had claims for securities,

because they had a legitimate expectation that securities had been purchased on

their behalf. Id. at 87.

The Court so concluded because under the Series 500 Rules, whether a

customer has a claim for securities depends upon whether the customer received a

written confirmation of a securities purchase. 17 C.F.R. § 300.502(a)(1). The

Court agreed that Rule 502’s focus on the receipt of a written confirmation meant

that it served to protect the legitimate expectations of customers, even if securities

were never purchased. “Under the Series 500 Rules, whether a claim is treated as

one for securities or cash depends not on what is actually in the customer’s account

but on what the customer has been told by the debtor in written confirmations.” Id.

at 86 (emphasis added). Consistent with this holding, the Trustee in this case is

treating all valid customer claims in this liquidation as claims for securities, despite


32

the fact that BLMIS (with few exceptions) did not purchase securities.

But this Court rejected the notion that the concept of legitimate expectations

could be imported from the Series 500 Rules into the calculation of net equity,

which has no “written confirmation” component to it. This Court deferred to the

conclusion of the SEC and SIPC that allocating customer property based upon the

amounts shown on fictitious account statements would be nonsensical and

inequitable and would threaten the SIPC fund. This Court noted that “basing

customer recoveries on ‘fictitious amounts in the firm’s books and records would

allow customers to recover arbitrary amounts that necessarily have no relation to

reality.’” 371 F.3d at 88. “SIPC and the SEC agree that such an approach is

irrational and unworkable and we defer to their unanimous and persuasive analysis

of the potential absurdities created by reliance on the entirely artificial numbers

contained in fictitious account statements.” Id.

Certain appellants argue that because the securities at issue in the New Times

I appeal were fictitious, and the securities listed on customer statements in this case

are real, the result should be different. (In fact, as noted above, this distinction is

not entirely true; for example, many trades were reported to have occurred at prices

that were outside the trading range on that day.) But customer expectations are

either part of the net equity calculus or they are not. They were not in New Times

I, and they should not be here either.


33

In any event, the profits reflected on the final account statements in this case

are equally as arbitrary, and as divorced from market reality, as the New Times I

account statements containing fictitious securities. In both cases, the profits

reflected on account statements, unbounded by the limitations of real-market

trading, were entirely engineered by a con man. Thus just as in New Times I, net

equity cannot be read to contain a concept of “legitimate expectations” that

subsumes the fictitious profits in this case.

Focht v. Athens (In re Old Naples Sec., Inc.), 311 B.R. 607 (M.D. Fla.

2002), another SIPA case, reached a similar conclusion. In that case, victims of a

Ponzi scheme were induced to purchase bogus certificates of deposit. Certain

claimants sought to recover not only their initial investments but also “phony

‘interest’ payments they received and rolled into another transaction.” 311 B.R. at

616. The court refused to calculate net equity based upon the phony interest

payments, calling the request “illogical.” “No one disputes that the interest

payments were not in fact interest at all, but were merely portions of other victims’

capital investments.” Id. at 617. If fictitious profits were considered part of net

equity, the court reasoned, “the fund would likely end up paying out more money

than was invested in [the] Ponzi scheme. This result is not consistent with the

goals of SIPA, which does not purport to make all victimized investors whole but


34

only to partially ameliorate the losses of certain classes of investors.”12 Id.

B. Customers Have No Legitimate Expectations In The Proceeds Of A Fraud.

To the extent that the concept of “legitimate expectations” has any relevance

to the net-equity inquiry, the claimants cannot articulate a legitimate expectation in

the proceeds of a fraud. The claimants’ final account statements are devoid of

market reality. By basing their net equity claims upon their fictitious securities

positions, the claimants seek to benefit from the results of the fraudulent scheme.

While an investor may have an expectation that he will receive the profits of a

fraudulent scheme, that expectation is not a legitimate one. See In re New Times

Secs. Servs., 463 F.3d 125, 130 (2d Cir. 2006) (“New Times II”) (“fictitious paper

profits” not “within the ambit of the customers’ ‘legitimate expectations’”);

Warfield v. Carnie, No. 04 CV 633, 2007 WL 1112591, at *13 (N.D. Tex. Apr. 13,

2007) (investor “could have no reasonable expectation of profiting from an illegal

Ponzi scheme.”).

That is particularly true for three reasons. First, the scheme has no real

“profits,” just money stolen from new participants. “If a person invests money

with the understanding that he will share in the profits produced by his investment,

12 Certain appellants try to distinguish Old Naples on the grounds that the claims were for cash, not securities. But that is a distinction without a difference. The court held that net equity did not include interest on the certificates of deposit, regardless of customer expectations, because the interest was fictitious.


35

and it turns out that there are no profits, it is difficult to see how that person can

make a claim to receive any more than the return of his principal investment.”

Lustig v. Weisz & Assocs., Inc. (In re Unified Commercial Capital), No. 01-MBK-

6004L, 2002 WL 32500567, at *8 (W.D.N.Y. June 21, 2002). “The false

representation by the Ponzi schemer that he is paying the investor his share of the

profits, which are in fact nothing more than funds invested by other victims, cannot

alter the fact that there are no profits to share.” Id.

Second, it would be difficult to imagine that a party could have a legitimate

expectation in distributions—or in account statements reflecting “profits”—that act

to perpetuate a fraud. Payments of fictitious profits, and account statements

showing additional fictitious profits, are used to lure new investors and continue

the Ponzi scheme. These “profits” are funded by later investors who are left

holding the bag when the scheme collapses. For that reason, courts in both SIPA

and non-SIPA cases have refused to entertain claims of fictitious profits by

investors in Ponzi schemes. See, e.g., In re Old Naples Sec., Inc., 311 B.R. at 616

(SIPA); SEC v. Credit Bancorp, Ltd., No. 99 CIV. 11395, 2000 WL 1752979, at

*40 (S.D.N.Y. Nov. 29, 2000) (non-SIPA).

Third, a claimant cannot have a legitimate expectation in transfers in excess

of his net investment because such transfers lack reasonably equivalent value.

Courts have held that investors have no legitimate claim on the “profits” of a Ponzi


36

scheme where they transferred nothing in exchange for those ill-gotten gains. See

Scholes v. Lehmann, 56 F.3d 750, 757 (7th Cir. 1995) (Ponzi-scheme investor “is

entitled to his profit only if the payment of that profit to him, which reduced the net

assets of the estate now administered by the receiver, was offset by an equivalent

benefit to the estate. It was not.”); In re Lake States Commodities, Inc., 253 B.R.

866, 872 (Bankr. N.D. Ill. 2000) (“Payments in excess of amounts invested are

considered fictitious profits because they do not represent a return on legitimate

investment activity.”) (citing cases).

It is true, as the appellants point out, that in New Times I, the net equity of

certain investors whose account statements reflected purchases of real securities,

but that were never purchased, was based upon the amounts set forth on those

statements, per the determination of the SIPA trustee. See New Times I, 371 F.3d

at 74-75. (That determination was never before this Court, as it was not appealed.)

But unlike here, those investors actually paid for the securities, which

promised a set rate of return. Accordingly, the claimants sought to recover

securities they had paid for, and would have had in their accounts, but for the

broker’s fraud. This was supported by the books and records of the broker, and, to

the extent relevant, was a legitimate expectation of the investors. Here, in contrast,

the appellants had not deposited sufficient funds to purchase the fictitious

securities listed on their account statements; the funds used to “purchase” the


37

securities were the fictitious “profits” of earlier phony transactions. And the

appellants could not have achieved those results in any event, because the trades

were manufactured in hindsight. Thus, in this case, calculating net equity based

upon the final customer statements would be to credit the fictional proceeds of the

fraud, which the books and records do not support, and which could not, as fraud,

constitute a legitimate customer expectation.

IV. BASING NET EQUITY ON FRAUDULENT CUSTOMER STATEMENTS WOULD CONFLICT WITH THE TRUSTEE’S AVOIDANCE POWERS.

Calculating net equity based upon the last customer statements is also

improper because distributing customer funds based upon the “results” of a Ponzi

scheme would irreconcilably conflict with the Trustee’s power under SIPA to

avoid fraudulent transfers. The Trustee has authority under SIPA to recover

property constituting a fraudulent transfer when, as here, customer property is not

sufficient to pay in full the claims of customers. See SIPA § 78fff-2(c)(3); see also

Picard v. Taylor (In re Park South Sec. LLC), 326 B.R. 505, 512 (Bankr. S.D.N.Y.

2005) (SIPA trustee has standing to avoid fraudulent transfers).

The SIPA Rules, which have the force of law, see In re Adler, Coleman

Clearing Corp., 195 B.R. 266, 275 (Bankr. S.D.N.Y. 1996), provide similarly. See

17 C.F.R. § 300.503(a) (“Nothing in these Series 500 Rules shall be construed as

limiting the rights of a trustee in a liquidation proceeding under the Act to avoid


38

any securities transaction as fraudulent, preferential, or otherwise voidable under

applicable law.”); 17 C.F.R. § 300.503(b) (“Nothing in these Series 500 Rules shall

be construed as limiting the right of the Securities Investor Protection Corporation .

. . to reject a claim for cash or a claim for securities if such claim arose out of a

securities transaction which could have been avoided in a liquidation proceeding

under the Act.”).

A. Payments Of Fictitious “Profits” In Furtherance Of A Ponzi Scheme Are Made With The Intent To Defraud And Are Not For Reasonably Equivalent Value.

Transfers made in furtherance of a Ponzi scheme in excess of a customer’s

net investment are fraudulent as a matter of law. First, transfers in furtherance of a

Ponzi scheme are presumptively made with intent to defraud. In re Manhattan Inv.

Fund Ltd., 397 B.R. 1, 8 (S.D.N.Y. 2007) (quoting 11 U.S.C. § 548(a)(1)(A));

Bayou Superfund, LLC v. WAM Long/Short Fund II, L.P. (In re Bayou Group,

LLC), 362 B.R. 624, 634 (Bankr. S.D.N.Y. 2007); Drenis v. Haligiannis, 452 F.

Supp. 2d 418, 429 (S.D.N.Y. 2006) (citing cases).

Second, Ponzi-scheme transfers in excess of a customer’s net investment are

not for reasonably equivalent value. A Ponzi-scheme investor pays nothing for any

distribution in excess of his capital investment: “A profit is not offset by anything;

it is the residuum of income that remains when costs are netted against revenues.”


39

Scholes, 56 F.3d at 757.13 As a result, “virtually every court to address the

question has held unflinchingly that to the extent that investors have received

payments in excess of the amounts they have invested, those payments are

voidable as fraudulent transfers[.]” In re Bayou Group, LLC, 362 B.R. at 635

(internal quotations and citation omitted); see also Sender v. Buchanan (In re

Hedged-Inv. Assoc., Inc.), 84 F.3d 1286, 1290 (10th Cir. 1996) (same); Wyle v.

C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589, 595 n.6 (9th Cir.

1991) (same); Terry v. June, 432 F. Supp. 2d 635, 642-43 (W.D. Va. 2006) (same);

Merrill v. Abbott (In re Indep. Clearing House Co.), 77 B.R. 843, 857 (D. Utah

1987) (same).14

Certain appellants argue that the Trustee lacks ability to avoid certain

fraudulent transfers because statutes of limitations apply. Even if that were true,

13 Some appellants argue that withdrawals of phony profits were “for value” because BLMIS, through its fraudulent customer statements, created an obligation that the withdrawals simply discharged. But even if the statements ostensibly created a legal obligation, the statements were fraudulent, and any obligations created thereby are themselves avoidable under the fraudulent transfer laws. See, e.g., 11 U.S.C. § 548(a)(1). Value cannot be created by means of a fraudulently derived obligation. 14 Some appellants cite a few cases that made an exception for Ponzi-scheme payments made under loan contracts with specified interest rates. See Unified Commercial Capital, Inc., 2002 WL 32500567; Daly v. Deptula (In re Carrozzella & Richardson), 286 B.R. 480 (D. Conn. 2002). But those decisions distinguish themselves from equity-based Ponzi schemes like this one. See, e.g., Unified Commercial Capital, 2002 WL 32500567, at *8; see also In re Bayou Group, LLC, 362 B.R. at 635-36 (distinguishing loan-contract cases). Moreover, the reasoning of these decisions has been challenged by other courts. See In re Hedged-Inv. Assocs., 84 F.3d 1286 (10th Cir. 1996), In re Independent Clearing House Co., 77 B.R. 843 (D. Utah 1987), and In re Taubman, 160 B.R. 964, 985-86 (Bankr. S.D. Ohio 1993) (all holding that contractual-interest portion of Ponzi investment is recoverable as fraudulent transfer).


40

the fact that the Trustee lacks the power to avoid certain transfers does not change

the fact that they are fraudulent. “[A]ll payments of fictitious profits are avoidable

as fraudulent transfers;” the statute of limitations simply “restricts the payments the

Ponzi scheme investor may be required to disgorge.”15 Donell v. Kowell, 533 F.3d

762, 772 (9th Cir. 2008). Others have contended that certain transfers were for

value. This may well be true, and the bona fides of these individual challenges will

be determined at a later point in the bankruptcy court’s proceeding.

In any event, even if certain transfers cannot be avoided, some can. Thus,

the appellants’ positions do not eliminate the inherent inconsistency between a

distribution scheme based upon fraud and the Trustee’s ability to avoid fraudulent

transfers.

B. Section 546(e) Of The Bankruptcy Code Does Not Prevent The Trustee From Avoiding Ponzi-Scheme Transfers.

Certain appellants incorrectly argue that 11 U.S.C. § 546(e) provides a

complete defense to all avoidance actions in this case. Section 546(e) provides that

a trustee cannot avoid certain margin or settlement payments made in connection

with “securities contracts.” A “securities contract” is defined in section 741(7) of

the Bankruptcy Code as “a contract for the purchase, sale, or loan of a security”—

15 Certain appellants contend that the use of the net investment method improperly circumvents statutory limitations on the Trustee’s avoidance powers. Not so. The use of the net investment method derives from the definition of net equity.


41

in other words, a specific agreement to buy, sell or loan a particular security.

The purpose of section 546(e) was to avoid potential disruptions to the

market occasioned by undoing settled purchases and sales. The rationale for

section 546(e) was “to minimize the displacement caused in the commodities and

securities markets in the event of a major bankruptcy involving those industries.”

H.R. Rep. No. 97-420, at 1 (1982), as reprinted in 1982 U.S.C.C.A.N. 583, 583.

See also Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund Ltd.), 310

B.R. 500, 513 (Bankr. S.D.N.Y. 2002); In re Integra Realty Res., Inc., 198 B.R.

352, 356 (D. Colo. 1996), aff’d, 354 F.3d 1246 (10th Cir. 2004). If security sale

and purchase transactions could be reversed, it would undermine confidence in the

system of guarantees and could lead to the “ripple effect” of bankruptcy filings by

other participants in the chain of guarantees. In re Adler, Coleman Clearing Corp.,

263 B.R. 406, 477 (S.D.N.Y. 2001).

This section has no application to this case, because Madoff never actually

traded in securities for customers, and thus never entered into securities contracts

on his investors’ behalf. While the investors generally gave Madoff the authority

to purchase and sell securities and options on their behalf, see In re BLMIS, 424

B.R. at 138, no such trades occurred. Here, since no securities were actually

purchased or sold, none of the potential disruptions to the market occasioned by

undoing settled purchases and sales would occur.


42

Moreover, courts have rejected the application of 546(e) to cases

“involv[ing] “illegality or transparent manipulation,” such as Ponzi schemes. In re

Grafton Partners, L.P., 321 B.R. 527, 539 (B.A.P. 9th Cir. 2005); see Wider v.

Wootton, 907 F.2d 570, 572-73 (5th Cir. 1990); In re Adler, Coleman Clearing

Corp., 263 B.R. at 478-80; Enron Corp. v. JP Morgan Secs., Inc. (In re Enron

Corp.), Nos. M-47 (GBD), 01-6034 (AJG), Adv. Nos. 03-92677 (AJG), 03-92682

(AJG), 2008 WL 281972, at *5 (S.D.N.Y. Jan. 25, 2008).

In any event, even if the agreements between BLMIS and its victims were

securities contracts, section 546(e) expressly excludes from its reach transactions

that are actually fraudulent. See 11 U.S.C. § 546(e) (intentional fraud avoidance

actions under section 548(a)(1)(A) are excluded). And as set forth above, transfers

made in furtherance of Ponzi schemes are, by definition, made with the intent to

defraud. See In re Manhattan Inv. Fund, 397 B.R. at 8; Drenis, 452 F. Supp. 2d at

429 (citing cases).

Some appellants argue that after Sharp International Corp. v. State Street

Bank and Trust Company (In re Sharp Int’l Corp.), 403 F.3d 43 (2d Cir. 2005), a

presumption of fraudulent intent—the so-called “Ponzi-scheme presumption”—is

no longer the law of this Circuit. See Sterling Equities, Doc. 185 at 25-27. But

Sharp involved a valid contractual debt that predated the fraud at issue, not

transfers made in furtherance of a Ponzi scheme, and courts after Sharp have


43

continued to apply the presumption. See In re Manhattan Inv. Fund, 397 B.R. at

10 (“Sharp did not involve a Ponzi scheme and the court did not discuss the Ponzi

scheme presumption. Therefore, there is no reason to ignore the long line of cases

that support the presumption’s continuing existence.”); In re Bayou Group, LLC,

362 B.R. at 638 (reaching the same conclusion).

And even if a presumption of fraudulent intent no longer existed in this

Circuit, it cannot be gainsaid that Madoff and his compatriots intended to further

perpetrate and conceal their scheme by distributing “profits” upon request. Thus,

section 546(e) does not reach transfers made to claimants in a Ponzi scheme, and

the provision does not eliminate the irreconcilable conflict between the appellants’

interpretation of net equity and the Trustee’s avoidance powers.

In the end, as the bankruptcy court held, whether the appellants “have

defenses to avoidance actions in this specific case does not change the inherent

inconsistency between the Last Statement Method and the Trustee’s avoidance

powers.” In re BLMIS, 424 B.R. at 136. “The fact that the Trustee may be unable

to avoid a transfer in particular circumstances, however, is irrelevant to the Court’s

finding that the power itself is inconsistent with a distribution scheme that credits

the reported products of a fraud.” Id. at 136-37.

“[T]he preferred meaning of a statutory provision is one that is consonant

with the rest of the statute.” Auburn Hous. Auth., 277 F.3d at 144. If the


44

appellants’ construction of net equity were upheld, the Trustee would have the

obligation to allocate customer property based upon the BLMIS fraud, but

simultaneously retain the authority to avoid transactions and recover property

transferred in furtherance of that same fraudulent scheme. The appellants have no

meaningful rejoinder to the inherent tension within SIPA that results from their

reading of net equity.

V. THE COURT SHOULD DEFER TO THE INTERPRETATION OF “NET EQUITY” ADVANCED BY SIPC AND THE SEC.

The Court should defer to the determination by the SEC and SIPC, which

are charged with enforcing and interpreting SIPA, that the definition of net equity

in SIPA requires use of the net investment method, not the last customer statement

method.

The SEC concurs that the language of SIPA dictates that “net equity” cannot

be based upon the fraudulent customer statements that Madoff generated, but

instead must be based upon the net investment method. The SEC reasons that the

definition of net equity must be read together with the “books and records” section

of the statute. See SIPA §§ 78lll(11), 78fff-2(b). As such, net equity must be

based upon the “books and records of the debtor” or “otherwise established to the

satisfaction of the trustee,” and the information on the fictitious customer

statements “does not satisfy either of the two conditions[.]” SEC Mem. of Law,

B.Dkt. 1052, at 3.


45

The last customer statements do not satisfy the “books and records”

exception, reasons the SEC, because “BLMIS’s other books and records contradict

the statements, showing that the securities positions were a complete fabrication

and that no securities were ever purchased for the accounts.” Id. And customers

cannot “otherwise establish” their net equity “to the satisfaction of the trustee”

using their statements, because “[t]he customers cannot show that they paid for the

securities positions on their last statements. Although arguably a customer’s initial

cash investment could be said to have ‘paid’ for the initial equity securities

‘purchases’ in the account, those securities were never ‘sold,’ which means that

any subsequent ‘purchases’ were made with fictitious dollars.” Id. at 3-4.

The SEC further reasons that the New Times cases support the net

investment approach. “[T]here is no meaningful difference between ‘fraudulent

promises made on fake securities’ (New Times II, 463 F.3d at 130) and fraudulent

promises involving positions in real securities that are fabricated through fictitious

backdated trades based on hindsight.” SEC Mem. of Law, B.Dkt. 1052, at 8.

“Both situations involve ‘fictitious paper profits’ and implicate the Second

Circuit’s concern that basing customer recoveries on fictitious amounts would

‘leave[] the SIPC fund unacceptably exposed[.]’” Id. (quoting New Times I, 371

F.3d at 88, quoting Br. of SEC as Amicus Curiae in New Times I at 16).


46

Finally, the SEC explains that to base “net equity” on fictitiously contrived

statements would “inequitably distort the pro rata distribution of customer

property held by the Trustee by favoring customers who invested years ago and

have already withdrawn the amounts they invested—at the expense of recent

customers that have not yet made significant withdrawals.” SEC Mem. of Law,

B.Dkt. 1052, at 8-9.

SIPC concurs with the SEC’s analysis and conclusion that “net equity” must

be calculated based upon a customer’s net investment, not fictitious customer

statements. SIPC explained to the bankruptcy court in great detail how only the

net investment method reflects the plain language of SIPA and its legislative

history, how the net investment method is the only approach consistent with the

New Times cases, and that calculating net equity based upon the customers’ last

statements would further Madoff’s fraud and lead to an inequitable distribution of

customer property. See SIPC Mem. of Law, B.Dkt. 519; SIPC Reply Mem. of

Law, B.Dkt. 1765.

In New Times I, this Court focused to a great degree on the interpretation of

SIPA by the SEC and SIPC. On the issue of whether customer claims based upon

fictitious securities were “claims for cash” or “claims for securities,” this Court

declined to afford Chevron deference to the SEC’s position that they were “claims

for securities” for several reasons: (1) its position matter was articulated for the


47

first time in an amicus brief solicited by this Court; (2) SIPC, not the SEC, had

primary responsibility for interpreting and enforcing SIPA; and (3) SIPC disagreed

with the SEC, arguing that they were “claims for cash.” See New Times I, 371

F.3d at 80-82; see generally Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837, 844

(1984). Instead, the Court granted more limited deference to the SEC’s

interpretation of SIPA under Skidmore v. Swift & Co., 323 U.S. 134, 139 (1944),

given the “‘specialized experience and broader investigations and information’

available to the agency.” See New Times I at 83.

The factors that precluded Chevron deference to the SEC’s interpretation of

the “claims for cash/claims for securities” issue in New Times I, however, are not

present here. First, SEC’s interpretation of net equity is not a matter of first

impression, but was set forth by the SEC in New Times I. In its amicus brief to this

Court in New Times I, the SEC explained, as here, that “net equity” must be

calculated based upon truthful information set forth in the firm’s books and

records, not fictitious information. As the SEC explained, “the requirement in

[Section 78-fff(2)(b)] that a trustee is to discharge a debtor’s obligations ‘insofar as

such obligations are ascertainable from the books and records of the debtor’

presupposes . . . that the figures in those books and records are accurate.” SEC Br.

in New Times I, J.A.V. II 101, 110. As it further reasoned, “[t]o apply the

securities valuation method set forth in [Section 78lll(11)] using fictitious amounts


48

in the firm’s books and records would allow customers to recover arbitrary

amounts that necessarily have no relation to reality . . . [and] leaves the SIPC fund

unacceptably exposed.” Id. (quoted in New Times I at 88).

Moreover, the SEC and SIPC agree that the net investment approach, not the

last statement approach, is the proper method to calculate net equity. While New

Times I did not expressly reach the matter of what level of deference applied, it

deferred on at least two occasions to the jointly held interpretations of the SEC and

SIPC. See New Times I at 81 (“Even if we were to view the text of the Series 500

Rules as ambiguous, we would defer to the SEC’s and SIPC’s common

interpretation.”); id. at 88 (“SIPC and the SEC agree that such an approach is

irrational and unworkable and we defer to their unanimous and persuasive analysis

of the potential absurdities created by reliance on the entirely artificial numbers

contained in fictitious account statements.”); see also id. at 79 (“We confine our

holding to the unique facts of this case where the SEC has offered a competing and

more persuasive interpretation of the statute. We do not consider what measure of

deference an SIPC interpretation might warrant under other circumstances, e.g.,

when it alone speaks to the meaning of one of its rules.”).

Should this Court not apply Chevron deference to the interpretation of net

equity jointly advanced by the SEC and SIPC, it should, at a minimum, afford their

joint interpretation Skidmore deference given the persuasiveness of their analysis.


49

See New Times I at 83 (ultimately, Skidmore deference hinges upon “all those

factors which give it power to persuade, if lacking power to control”) (quoting

Skidmore, 323 U.S. at 140). The joint determination of the SEC and SIPC that net

equity must be calculated based upon the net-investment method, not fictitious

customer statements, is persuasive—not only because of the intellectual force of

the analysis, but because their conclusion is the only one consistent with the plain

language of the statute, with other provisions of SIPA and the bankruptcy code,

with this Court’s jurisprudence, and with equity.

VI. JUDICIAL ESTOPPEL HAS NO APPLICATION HERE.

Various appellants argue that the Trustee, SIPC, and the SEC should be

judicially estopped from defending the bankruptcy court’s determination on

appeal, ostensibly on the ground that their positions in New Times I on net equity

differ from their positions here. But judicial estoppel has no application in this

case, for a variety of reasons.

First, judicial estoppel applies only to factual, not legal positions. See, e.g.,

Troll Co. v. Uneeda Doll Co., 483 F.3d 150, 155 n.7 (2d Cir. 2007). The

interpretation of a statute is a legal determination, not a factual one. See New

Times I, 371 F.3d at 75. The appellants concede this point when arguing for de

novo review. Judicial estoppel thus does not apply.


50

Second, judicial estoppel has no application to the Trustee, who is legally

distinct from SIPC and who was not a party to the New Times cases. While a

trustee is named by SIPC, once appointed by the Court, the trustee does not act

under SIPC’s control. Cf. SIPC v. Morgan, Kennedy & Co., 533 F.2d 1314, 1316

(2d Cir. 1976) (case in which SIPC and SIPA trustee disagreed on construction of

SIPA).

Third, no appellant argued below that the SEC was judicially estopped from

articulating its position in this case, waiving the argument. See In re Nortel

Networks Corp. Sec. Litig., 539 F.3d at 132.

Fourth, the judicial estoppel arguments directed at the SEC and SIPC are

based upon the false premise that their positions in New Times I cannot be

reconciled with their positions here. This Court has explained that if “statements

can be reconciled there is no occasion to apply an estoppel.” Simon v. Safelite

Glass Corp., 128 F.3d 68, 73 (2d Cir. 1997). While SIPC supported the

recognition of gains earned in the marketplace by mutual funds that customers had

actually ordered and paid for (a position that the SEC did not weigh in on, as the

issue was not appealed and the SEC became an amicus curiae only on appeal to

this Court), SIPC and the SEC agreed that net equity could not include “profits”

reflected on customer statements that were wholly the imagination of a fraudster

and wholly disconnected from market reality. They also agreed that net equity


51

could not be calculated without reference to the broker’s books and records, which

reflect what customers actually ordered and purchased. These positions are

consistent with their positions in this case.

VII. THE NET INVESTMENT METHOD MIRRORS THE STANDARD JUDICIAL TREATMENT OF PONZI SCHEMES.

The net investment method mirrors how courts generally treat claims and

claimants in Ponzi scheme cases. The hallmark of a Ponzi scheme is that investors

are promised—and shown or actually paid—high returns on some seemingly

money-making venture when, in reality, there are no such profits and, often, not

even such a venture. Instead, initial investors are paid from monies provided by

other later investors. The word of the fake “profits” and the supposedly positive

experience of the initial investors serve to bring more funds into the scheme. See

Cunningham v. Brown, 265 U.S. 1, 13 (1924) (describing the scheme of Charles

Ponzi and stressing the importance of treating victims in such a scheme equally).

When faced with the particular circumstances of Ponzi schemes, where there

is not enough money to repay all victims in full, courts have routinely taken the

position that investors are entitled to share proportionally to their actual losses on

dollars invested, not based on the “fictitious” profits, and that funds that they

received back during the course of the scheme must be deducted. Such an

approach is consistent with the fundamental principle, whether under equity,


52

bankruptcy, or SIPA, that in any distribution, similarly situated investors must be

treated alike.

In Cunningham, the Supreme Court set forth the principle that all investors

in a Ponzi scheme must be treated equally and that “equality is equity and this is

the spirit of the bankrupt law.” 265 U.S. at 13. To recognize fictitious gains

would do precisely the opposite—it would unfairly require more recent investors to

give up a share of their actual dollars to subsidize earlier investors, whose accounts

appeared on paper to have accrued additional fictitious profits. Accordingly,

courts generally hold that when a Ponzi scheme collapses, and there is not enough

money to repay all the funds invested by victims, the victims should recover

proportionately in accordance with their respective actual losses, i.e., their

unrecovered cash investments, not their phony inflated profits. See, e.g., CFTC v.

Topworth Int’l, Ltd., 205 F.3d 1107, 1115-16 (9th Cir. 2000); Official Cattle

Contract Holders Comm. v. Commons (In re Tedlock Cattle Co.), 552 F.2d 1351

(9th Cir. 1977) (per curiam); CFTC v. Equity Fin. Group, LLC, No. Civ. 04-1512,

2005 WL 2143975, at *22-24 (D.N.J. Sept. 2, 2005), adopted in No. Civ. 04-1512,

2005 WL 2864783 (D.N.J. Oct. 26, 2005); In re Old Naples Sec., Inc., 311 B.R. at

616-17; SEC v. Credit Bancorp, Ltd., No. 99 CIV. 11395, 2000 WL 1752979, at

*40-41 (S.D.N.Y. Nov. 29, 2000), aff’d, 290 F.3d 80 (2d Cir. 2002).


53

In SEC v. Credit Bancorp, Ltd., the district court was presented with

competing distribution proposals in a Ponzi-scheme receivership. The court

adopted a net investment approach instead of a fictitious profits approach: “[I]t is

in the nature of a Ponzi scheme that customer returns are generated not from

legitimate business activity but, rather, through the influx of resources from new

customers. Since all the funds were obtained by fraud, to allow some investors to

stand behind the fiction that [the] Ponzi scheme had legitimately withdrawn money

to pay them ‘would be carrying the fiction to a fantastic conclusion.” 2000 WL

1752979 at *40 (internal quotations omitted). As the court pointed out,

“permitting customers to retain such gains comes at the expense of the other

customers.” Id. Moreover, the court reasoned, “recognizing claims to profits from

an illegal financial scheme is contrary to public policy because it serves to

legitimate the scheme.” Id. (internal citations omitted). These rationales apply

with equal force here.

VIII. BASING NET EQUITY UPON FICTITIOUS CUSTOMER STATEMENTS WOULD BE INEQUITABLE.

Calculating net equity based upon fictitious transactions is not only

inconsistent with SIPA, it is inequitable. As noted in Cunningham, 265 U.S. at 13,

in a Ponzi scheme, as among equally innocent victims, “equality is equity.” In a

scheme such as Madoff’s, although many victims are sympathetic, the fact remains

that there are limited funds to distribute. As in all Ponzi schemes, the investors


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who obtained “profits” were paid using the money of other investors, and the latter

should not be made to suffer disproportionately. Treating the phony “profits”

concocted by Madoff and his coconspirators as real would reward claimants who

have already received back all their capital at the expense of those who have not.

It would force the Trustee to take the over $1.5 billion fund of customer property

recovered to date and continue to use it to pay those who already received other

customer’s money in addition to their own.16 A slavish adherence to the final

fictitious customer statements—in spite of all of the evidence demonstrating the

falsity of those statements with respect to securities transactions—would permit

Madoff to determine who wins and loses. Doing so would be contrary to the

strong consensus among courts that have dealt with Ponzi scheme distributions that

a net investment approach is the most equitable means to allocate limited resources

among equally deserving victims.

To allocate limited resources based upon the final fictitious BLMIS

customer statements would also be poor public policy. The position of the

appellants amounts to this: if a broker-dealer pretends to have purchased securities

in fictional transactions with imaginary money at orchestrated prices that are

impossible under normal and orderly functioning of the markets, the SIPA trustee

16 See hypothetical in In re BLMIS, 424 B.R. at 141, explaining how use of the last statement method would affect the recovery of those who never withdrew funds.


55

may not look behind the pretense but must pay out money and assets as if each

supposed transaction were a real and normal part of the legitimate securities

commerce of this country. In other words, the appellants would have the

obligations of the SIPA trustee and SIPC, a quasi-public entity, determined solely

by the fantasies of a fraudster. Nothing in the language of SIPA or case law

dictates such a result.


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CONCLUSION

For the foregoing reasons, and the reasons set forth in the briefs of the SEC

and SIPC, the Trustee respectfully requests that the Court affirm the decision of the

bankruptcy court.

Dated: New York, New York September 20, 2010

BAKER & HOSTETLER LLP

By: /s/ David J. Sheehan David J. Sheehan Thomas D. Warren Wendy J. Gibson Seanna R. Brown 45 Rockefeller Plaza New York, New York 10111 Telephone: (212) 589-4200 Facsimile: (212) 589-4201 [email protected] [email protected] [email protected] [email protected] Attorneys for Defendant Irving H. Picard, Trustee for the Substantively Consolidated SIPA Liquidation of Bernard L. Madoff Investment Securities LLC and Bernard L. Madoff


CERTIFICATE OF COMPLIANCE WITH TYPE-VOLUME LIMITATION, TYPEFACE REQUIREMENTS AND TYPE STYLE

REQUIREMENTS

This brief complies with the type-volume limitation of Fed. R. App. P.

32(a)(7)(B) because this brief contains 13,366 words, excluding the parts of the

brief exempted by Fed. R. App. P. 32(a)(7)(B)(iii).

This brief complies with the typeface requirements of Fed. R. App. P.

32(a)(5) and the type style requirements of Fed. R. App. P. 32(a)(6) because this

brief has been prepared in a proportionally spaced typeface using Microsoft Office

Word 2003 in 14-point Times New Roman font.

Dated: New York, New York September 20, 2010

BAKER & HOSTETLER LLP

By: /s/ David J. Sheehan David J. Sheehan Thomas D. Warren Wendy J. Gibson Seanna R. Brown

45 Rockefeller Plaza New York, New York 10111 Telephone: (212) 589-4200 Facsimile: (212) 589-4201 [email protected] [email protected] PNC Center 1900 East 9th Street, Suite 3200 Cleveland, Ohio 44114 [email protected] [email protected] Attorneys for Appellee Irving H. Picard,


Trustee for the Substantively Consolidated SIPA Liquidation of Bernard L. Madoff Investment Securities LLC and Bernard L. Madoff


UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT In re: BERNARD L. MADOFF INVESTMENT SECURITIES LLC, Debtor.

CERTIFICATE OF SERVICE

No. 10-2378-bk

I, David J. Sheehan, hereby certify that on September 20, 2010, I caused a

true and correct copy of the brief for Trustee-Appellee Irving H. Picard, as Trustee

for the Substantively Consolidated SIPA Liquidation of Bernard L. Madoff

Investment Securities LLC and Bernard L. Madoff, to be filed with the Court

electronically and by hand and served upon the parties who receive electronic

service through CM/ECF, as listed on Schedule A, and served upon parties by

Overnight Delivery, as listed on Schedule B.


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Schedule A

Via Electronic Service

Securities Investor Protection Corporation 805 15th Street, N.W., Suite 800 Washington, D.C. 20005 Josephine Wang, Esq. Kevin Bell, Esq. Hemant Sharma, Esq.

Becker & Poliakoff, LLP Helen Davis Chaitman, Esq. 45 Broadway New York, NY 10006

Bernfeld, DeMatteo & Bernfeld, LLP Jeffrey L. Bernfeld, Esq. David B. Bernfeld, Esq. 600 Third Avenue, 15th Floor New York, New York 10016

Brunelle & Hadjikow, P.C. Timothy P. Kebbe, Esq. Suite 1825 1 Whitehall Street New York, NY 10004

Davis Polk & Wardwell LLP Karen E. Wagner, Esq. Brian S. Weinstein, Esq. Jonathan D. Martin, Esq. 450 Lexington Avenue New York, NY 10017

Dewey & LeBoeuf LLP Kelly A. Librera, Esq. Seth C. Farber, Esq. 1301 Avenue of the Americas New York, NY10019-6092

Gibbons P.C. Donald Abraham, Esq. Jeffrey A. Mitchell, Esq. One Pennsylvania Plaza, 37th Floor New York, New York 10119

Goodwin Procter LLP Daniel M. Glosband, Esq. 53 State Street Boston, Massachusetts 02109 Goodwin Procter LLP Larkin M. Morton, Esq. The New York Times Building 620 Eighth Avenue New York, New York 10018

Kleinberg, Kaplan, Wolf & Cohen P.C. David Parker, Esq. Matthew J. Gold, Esq. Jason A. Otto, Esq. 551 Fifth Avenue-18th Floor New York, NY 10176

Lax & Neville, LLP Brian J. Neville, Esq. Barry R. Lax, Esq. Brian D. Maddox, Esq. Suite 1407 1412 Broadway New York, NY 10018


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Milberg LLP Jonathan M. Landers, Esq. Matthew Gluck, Esq. Brad N. Freidman, Esq. Sanford P. Dumain, Esq. Jennifer L. Young. Esq. One Pennsylvania Plaza 48th Floor New York, NY 10119

Phillips Nizer LLP Chryssa V. Valletta, Esq. 666 Fifth Avenue New York, New York 10103

Seeger Weiss LLP Steven A. Weiss, Esq. Christopher M. Van de Kieft, Esq. Parvin Aminolroaya, Esq. One William Street New York, NY 10004

Shearman & Sterling LLP Stephen Fishbein, Esq. James Garrity, Esq. Richard Schwed, Esq. 599 Lexington Avenue New York, NY 10022-6069

Smith Valliere, PLLC Mark Warren Smith, Esq. Suite 1510 509 Madison Avenue New York, NY 10022

Sonnenschein Nath & Rosenthal LLP Carole Neville, Esq. 1221 Avenue of the Americas New York, New York 10020

Stanley Dale Cohen, Esq. 41 Park Avenue Suite 17-F New York, NY 10016

Lawrence R. Velvel, Esq. Massachusetts School of Law 500 Federal Street Andover, MA 01810


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Schedule B

Via Overnight Delivery

United States Securities and Exchange Commission Katharine B. Gresham, Esq. 100 F Street., NE Washington, DC 20549

Marshall W. Krause, Esq. P.O. Box 70 San Geronimo, CA 94963


Madoff Net Equity Appellate Brief

Documents

Transcript of Madoff Net Equity Appellate Brief